Friday, April 8, 2011

Magic Formula Retailers

Oh dear, retailers haven't been fairing so well lately, have they? CPR.L (Carpetright) recently issued a profit warning, as reported on Stockopedia. DXNS.L (Dixons) recent trading statement also reported deteriorating conditions. The stock market pros have been shuffling their holdings in Dixons throughout last week. Nearly all of them are lightening up their holdings on Dixons, according to the RNS filings, with only Skagen reporting an increase in their stake. It should be noted that in this article I am only concentrating on "general" retailers, and specifically excluding food and drug retailers, for whom I have a much different perception.

Overdone share price drops, or more yet to come? More on that later, but first some statistics. Here are a complete list of retailers that pass on my Magic Formula screen, together with some stats:

DEB  1.1  -517     97 3.1 DEBENHAMS
SMWH 5.2    56     69 4.8 WH SMITH
NXT  6.0  -530    400 3.9 NEXT
JD.  5.4    60     43 2.3 JD. SPORTS FASHION
DXNS 2.7  -220     60 0.0 DIXONS
HOME 3.5   364    209 7.2 HOME RETAIL

EPIC - company code
Z - z-score - above 3 is acceptable, below 3 is much more marginal
CASH - net cash in £m. Negatives imply net debt
PROFIT - profit £m for latest financial year
YLD - dividend yield %
NAME - name of the company

Note that the cash and profit figures for JD., DXNS and HOME are the latest available year-end figures, which are over 6 months old. Be warned. Figures are taken from Sharelock Holmes. The first take-away from the table is that some companies are sitting on cash, and some are saddled with debt. Applying a strict z-score filter of at least 3 would lead us to rule out DEB and DXNS immediately. A measure of debt on a cash to profit basis doesn't make them look too bad for them at first flush, though. Still, if you're going to choose a magic formula stock, then why not favour the ones with a lot of money to spend?

So. Retailers. Are they a buy?

With the likes of Dixons trading on PERs of 7, and retailers having taken a beating, is it time to now back up the truck?

THE BULL CASE: In his article Dixons in the dock, Kevin Murphy, of Schroders, argued that there was a window of opportunity for value investors. He notes that at 12p, DXNS trades very near its 2008 all-time low. Its bonds yield 12%, compared to early 2009, when they yielded 20%. He further comments that at a yield of 12%, the bondholders obviously do not consider the company risk-free, but that there is reason to suppose that it is putting its house in order.

THE BEAR CASE: Simply put, things are getting visibly worse: VAT hikes, government cutbacks, rising input costs, employment insecurity and low wage inflation don't bode well. About the only good news is that the Bank of England are unlikely to put up interest rates any time soon - although one could posit a bear case even for the current state of interest rates. Now, you could argue that with so much bad news reflected in share prices, the companies are a steal. I would urge caution on that front, as I fear that potential investors may be walking into a classic value trap. IF profits take further significant beatings (and I have no sagely insight as to what will really happen, other than that things aren't looking too good at the moment), then
those low multiples will probably offer no downside protection to the investor. In the dire words of Peter Lynch: buying cyclicals on low PEs is a proven way to lose money. The lesson of HMV.L looms large in my mind. Now there's one sick puppy that kept sliding, sliding, sliding, and then sliding some more. Just make sure that if you buy, you're not buying into another HMV.

I actually hold JD.

I haven't really thought much about all the retailing stocks in the magic formula list, but I would rule out DEB and DXNS, given that there are better alternatives. When I went into DEB last, it seemed to have more shop staff than customers. The JD. shop I went in was small, and whilst not bustling with trade, at least the (paying!) customer to staff ratio was greater than 1. I'm not sure about HOME. My dad doesn't like them, I know that. I think NXT and SMWH might be reasonable buys, with a preference given to SMWH on account of its cash position. Besides, everyone still needs stationery, right?

So, why do I hold JD.? Well, it is a magic formula stock, and trades at a PER of 7.8. That doesn't stop it from being a value trap, of course. The yield isn't great, but I'm not going to overfuss on that. In January of this year, the company reported increased like-for-like sales during the christmas period, and maintained its gross profit margins. That's in stark constrast to some other retailers, who really felt some pain over christmas. It appears that the snow that affected the weak retailers somehow didn't present much of an obstacle for JD.. Peculiar that, isn't it? JD. did note, however, that it expects tough trading conditions this year. JD. will make a preliminary 2010  earnings statement on the 13 Apr, so I think we'll get to see if I was woefully wrong, or not. Some encouraging news is that JD. has a strong balance sheet, likes to operate in niche areas, and has been buying up some of the competition that has fallen by the wayside. Even if we see declining like-for-likes, we could well see increased revenues and profits. "Yes, but the like-for-likes are declining", I hear you object. My counter-argument would be yes, fair enough, the company is facing tough conditions, but it is buying up the weaklings on the cheap. If and when conditions do improve (and it's by no means certain that like-for-like will drop), I think JD. will have shown itself to have made some shrewd purchases. I am also encouraged to see that JD. has withdrawn from the bidding of JJB Sport. It gives me some confidence that the directors are being selective in their purchases, and are not just buying any thing at any price. Admittedly, there are risks of share price deterioration.

My Magic Formula Screen
In his book, "The Little Book That Beats The market", Joel Greenblatt laid out an investment formula for selecting a portfolio of shares that should beat the market over the long term. His formula contains a few grey areas. Sharelock Holmes has a screen for Greenblatt; although it is unlikely to be an exact replication of the formula. It is proably "good enough", though. As part of my filter, I select companies with a market capitalisation of at least £300m. Investment Trusts are excluded, not least because the database doesn't hold their details. They are unlikely to be suitable candidates in any evernt. As at March 2011, this yields a universe approaching 400 companies, which is a goodly selection to choose from. I then focus on the top 40 stocks within that universe.

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